Econ 101: Competition and Prices

In simplest terms, when a company makes a product that turns out to be profitable, other companies wanting to copy their success will drive prices lower in order to take some of their business. This kind of “price war” tends to go on until prices are as low as they may be while still allowing the producer to make a profit. In fact, the most efficient producers will tend to drive the less efficient ones out of business by their ability to sell the product profitably at prices that the less efficient producers cannot match.

Competition among buyers also greatly affects the market, though in modern society this is less obvious than it may have been in the past. Higher demand for goods and services drives those prices up these days when the producer notices that their supply is unable to keep up. The producer doesn’t want to miss out on profits, so when they notice the shortage they will both a) try to provide more of the desired good or service and b) raise the price so that they can maximize the profit they realize on the goods and services sold. If they overshoot the mark and raise the price too high or produce the good or service in too great a quantity, they will eventually notice this overage and lower the price again until they can sell all the products for the most profit.

The price settled on is known as the “profit-maximizing price” or the “market-clearing price,” since it should allow all units of a good to be sold without any shortages or surpluses and thus “clear the market” for that good. When this price is settled on, the market is said to be in “equilibrium.” The thing is, the process for arriving at this price is never perfect, and indeed, as peoples’ tastes change, the profit-maximizing price may change as well. For this reason, the free market is said to “tend towards equilibrium,” but should not actually be thought of as being “in equilibrium.”

My point here is that competition is the mechanism for setting prices in a free market. Prices are extremely important for determining whether the market for a good or service is cleared, for determining whether a seller is seeing profits or losses, and determining which goods and services continue to be produced. Without competition and a price system, there would be no way for producers to know for sure that they were using their resources wisely in ways that would satisfy demand. More on this in future posts…